05 June 2006

Backdating: What is your E-Discovery Readiness Factor?

There is additional volatility in the wind as the SEC steps up investigations of "Stock Option" grants prior to August of 2002. The focus is on Backdating of Grants to executives and whether the grant dates were backdated to a time when the stock price was at it's lowest. Stock Option grants are to be priced with an exercise price that equals the current price of the stock. "Backdating" is the intentional grant date setting to a point in the past when the price was lower, so to increase the gain upon exercising.

In general, government probes are being launched to determine whether the grants were backdated to a point shortly before the company announced good news, so option holders could capitalize on a lower market value. Although the practice is considered controversial by many investors, backdating is legal if disclosed in regulatory filings, allowed by the company's own policies, and accounted for properly.

Six of the 22 companies named in the Moody's report are rated by the agency. They are: Affiliated Computer Services, American Tower, Caremark Rx, Jabil Circuit, Juniper Networks, and UnitedHealth Group.

What are the implications?

Accounting restatements to start with. Tax issues to follow. Even the resignations of senior executives in the midst of a continuing investigation by the SEC and Justice Department. The fact is that backdating is a credit risk on paper. It is an Operational Risk in behavior.

Be prepared to produce all relevant records upon receipt of the discovery request. Even the most proactive organizations are already doing their own internal reviews before the financial auditors ask for this information. Send a message to all relevant personnel responsible for the information archives to be ready to produce the documents on all stock option grants for new hires and executives who receive regular grants as part of their total compensation.

Compensation Committee's will soon be dictating that future grant option dates be timed for the "open window" after earnings announcements. This will increase the confidence that executives are not getting special treatment upon hiring or for annual performance bonuses. Look to the savvy organizations to also time their annual performance reviews with employees so that any other stock option grants are done so in the next calendar "open window".

That's according to a shareholder derivative lawsuit filed against the company in federal court here.

The company denies that any backdating of options occurred.

The plaintiff threat is now gaining momentum and it would be in most high profile companies to recheck their "E-Discovery" Readiness Factor. The documents produced five or six years ago will no doubt be under the magnifying glass of the auditors and investigators in the weeks and months ahead.

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Operational Risk is defined as the risk of loss resulting from inadequate or failed processes, people, and systems or from external events. The definition includes legal risk, which is the risk of loss resulting from failure to comply with laws as well as prudent ethical standards and contractual obligations. It also includes exposure to litigation from all aspects of an institutions activities.

"The Only Thing Necessary For Evil To Triumph Is For Good Men To Do Nothing." --E. Burke